He supports this argument with the observation that the PE ratio of Tech stocks in the S&P 500 is still under 20.

What are the limitations of using the PE ratio for a basket of stocks to measure the valuation of the portfolio when some stocks in the portfolio have negative earnings?

Does an analysis of the PE ratios of the stocks in the Vanguard Information Technology ETF support or contradict Professor Siegel’s view on the valuation of Tech stocks?

Is Professor Siegel correct in his assertion that tech stocks are valued correctly?

Discussion of ETF PE Ratios:

Professor Siegel pointing to a PE ratio for a basket of tech stocks in the S&P 500 has argued that the sector is valued fairly. My problem with this argument is that published statistics on ETF PE ratios often fail to accurately include information on firms with negative earnings.

Firms with negative earnings have negative PE ratios. These firms often have a lot in common with high PE firms. Often startups have negative or low earnings. If earnings are negative the PE is negative. If earnings are slightly positive the PE is large.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income. Some web sites including yahoo finance report and include negative PE ratios. Most analysts omit negative PE ratios from their calculation of the portfolio PE. However, this procedure will also understate valuation relative to income because firms with negative PE ratios have high valuation compared to earnings.

PE ratios have no clear economic interpretation when earnings are negative. When earnings are slightly below zero (a small loss) the PE ratio is a very large negative number. When a company has a larger loss the PE ratio is a smaller negative number.

It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income. Some web sites including yahoo finance report and include negative PE ratios.

Most analysts omit negative PE ratios from their calculation of the portfolio PE. However, this procedure will also understate valuation relative to income because the firm with a negative PE ratio has a high valuation compared to earnings.

I am not the first to write about the problem of measuring ETF PE ratios. Here are some additional resources.

Vanguard Technology Fund VGT has a total of 356 firms. This study examined the PE ratios of all firms where the equity investment was greater than or equal to 0.1 percent of the value of the VGT portfolio. There were 109 such firms.

Results: The frequency distribution of dollar share values invested and number of firms for five PE categories – less than zero, 0 to 15, 15 to 30, 30 to 40 and over 40 – are presented below.

Shares of Firms in VGT by PE category

PE Category

Dollar Share Invested by PE Category

Percent of Companies

<0

6.31

17.43

0-15

5.74

6.42

15-30

36.19

34.86

30-40

31.16

12.84

40<

13.12

28.44

Total

92.52

100

Sample consists firms in VGT where the equity position was greater than or equal to 0.1 percent of the total value of the VGT portfolio. There were 109 firms meeting this criterion. These 109 firms represent 92.5 percent of the value of the VGT Portfolio.

Observations:

Around 6.3 percent of dollars invested in the 109 positions of VGT are in firms with negative earnings. Around 17.4 percent of the 109 firms had negative earnings.

Over 13 percent of dollars invested in the 109 VGT positions had PE ratios over 40. Over 128 percent of the firms in this group had a PE ratio over 40.

Analysis:

What can we conclude about the question of whether tech stocks are overvalued after examining the distribution of stocks in VGT?

The large number of tech stocks with high PE ratios or worse yet negative earnings is consistent with a bubble. Perhaps the bubble is in the early stages and some people can buy, sell, and make money before the crash. However, there are a lot of overtly optimistic analysts and a lot of inaccurate or misleading information out there.